India Monetary Policy: MPC Faces A Changed World In Just Two Months

The Reserve Bank of India’s Monetary Policy Committee meets from Dec. 3 to Dec. 5 for its fifth bi-monthly statement of this fiscal year. In its previous meeting on Oct. 5, the MPC decided to keep the policy repo rate unchanged at 6.5 percent by a 5-1 vote. Simultaneously, it decided to change the policy stance to “calibrated tightening” from “neutral” by a similar vote. Interestingly, the dissenting vote on policy rate was for a hike of 25 basis points whereas the dissenting vote on policy stance was to keep it at “neutral”.

Since the last policy decision, there has been a sea change in the financial markets.

The Backdrop To The Last Meeting

The October MPC meeting was held after a sharp rise in international crude oil prices, a rise in the bond yields of major developed economies, and U.S. dollar appreciation; which in turn led to a sell-off in emerging market assets and put significant pressure on EM currencies. The escalating trade tensions between U.S. and China, as well as sanctions on Iran, were the key factors driving market volatility.

In fact, several leading banks were forecasting crude oil prices to touch $100 as a result of supply constraints.

Rising rates in developed markets and high crude oil prices both impact India’s macroeconomic balance adversely. The current account deficit widens due to a higher import bill and our dependence on portfolio flows to fund this deficit increases.

In such a scenario, the withdrawal of money by foreign portfolio investors due to rising global yields, risk aversion, and lower dollar liquidity acted as a double whammy resulting in a sharp fall in the rupee’s exchange rate. Both, the depreciating rupee and higher crude oil prices, adversely impact domestic growth and inflation. As inflation is the main policy target for the MPC, the market starts expecting higher future policy rates.

The October monetary policy report noted that “At its peak, the impact of the 10 percent increase in crude oil price shock is expected to reduce growth by 15 basis points and push up headline inflation by around 20 basis points”.

Significant Drop In Oil, Bond Yields

Ironically, crude oil prices have since retraced sharply. At the time of writing, the price of Brent crude was around $60 per barrel, 31 percent lower than the high of $87 per barrel in early October. At these prices, oil prices are back to where they were a year ago. And now the market is fretting about over-supply. There is a talk of production cuts by OPEC in its next meeting on Dec 5.

In a similar vein, the yield of benchmark 10-year U.S. treasuries has seen a pull-back to 3 percent level from a high of 3.25 percent seen in early October. In his speech at The Economic Club of New York on Nov. 28, Federal Reserve Chairman Jerome Powell said that the Fed’s benchmark interest rate was “just below” the neutral level.

Wall Street widely interpreted this as an indication that the Fed may be nearing the end of its rate hiking cycle.

This contrasts with his statement about a month ago that the Fed was “a long way” from neutral which sparked the concern that the rate increases would have a stifling impact on growth. To be sure, the market still expects the Fed to raise rates at its next meeting on Dec. 18-19.

With such a dramatic shift, the global conditions have started to appear a lot more benign as compared to two months ago. This is partly reflected in the sharp recovery of the rupee which has appreciated by over 6 percent against the U.S. dollar during this period.

Benign Inflation, Growth Subdued

On the domestic front, the headline Consumer Price Index inflation continues to be benign, driven by low food and vegetable prices. The latest print for October came in at 3.31 percent, below the consensus estimate of 3.6 percent.

The estimate of core CPI inflation, after stripping away the volatile food and fuel components, continues to be worryingly high, at above 6 percent. It has been above 5 percent for over 9 months now and had it not been for very low inflation in food and vegetable prices, headline CPI would have printed much higher.

Growth data continues to be a mixed bag. After registering an 8.2 percent growth in the first quarter, the second quarter estimate of real GDP growth came in at 7.1 percent, much lower than the consensus estimate of 7.5 percent.

For the full year, real GDP growth will likely be lower than RBI’s estimate of 7.4 percent.

It is expected that the lagged effect of higher interest rates, rupee depreciation in the first half, and tighter credit availability will have an adverse impact on economic activity.

Given this scenario, it is likely that as far as policy rates are concerned, the MPC will adopt a wait and watch approach. Some expect that the policy bias may be shifted back to “neutral”. However, given the volatility in international crude oil prices, it may be too early to do that. the MPC will likely want to see a continuation of the latest trend with some stability in crude oil prices and the rupee before making that change.

During the last two months, liquidity in the banking system has been a big focus for the government. There have been repeated demands from the industry as well for RBI to proactively provide liquidity in general, and specifically to the beleaguered NBFC sector. Traditionally, the MPC statement has focused on the policy rate, leaving the day-to-day management of liquidity to the relevant departments of the RBI.

In the previous post-policy conference, Deputy Governor Viral Acharya said that “The Reserve Bank will continue to proactively manage the system liquidity so as to achieve the monetary policy objective of aligning the overnight weighted average call rate with the policy rate, while also meeting economy’s demand for reserve money growth.”

In the recent past, the overall system liquidity has tended to be in significant deficit mode even though the call money rate has been well-behaved. Banks have been relying heavily on RBI for giving the liquidity through its repo operations.

"" - It is expected that over the next few months this deficit will worsen further.

To its credit, the RBI has already bought bonds worth Rs 10,600 crore so far in its open market operations since mid-September. It plans to buy another Rs 40,000 crore in December. Still, it may not be enough to address the forecasted liquidity deficit.

"RBI needs to announce a more aggressive OMO calendar for the next three months to ensure that the liquidity deficit worries are addressed properly."

There could be a concern that if the current situation persists and RBI was to end up buying dollars to support the rupee, then it may not need to inject so much durable liquidity through OMOs. It can, however, be easily addressed by RBI having the option of aborting the calendar if the situation so demands.

Neeraj Gambhir is an independent financial market expert.

The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.